How do Commercial Banks create Credit Explain
Commercial Banks Create Credit
The term credit is an evolution of a Latin word “credo” which means “I entrust and i put my faith in. The word credit has been described by GIDE in the following ways.
“An exchange which is complete after the expiry of certain period of time after payment”.
In simple words credit means a Loan.
Credit Creation: –
The creation of credit or deposit is one of the most important functions of commercial banks. Like other corporations banks aim at earning profits. Credit creation is the multiple expansions of banks demand deposits. When a bank advances a loan, it does not pay the amount in cash, but it opens a curr nt account in his name and allows him to withdraw the sum by cheque. In this way the banks create deposit or credit. It s an open secret that banks advance a major portion of their deposits to the borrowers and keep smaller part of them for payment to the customers on demand.
“The tendency on the part of commercial banks to expend their demand deposits as a multiple of their excess cash reserves is known as creation of credit”
According to Prof Crowther:-
“The important work of bank is to provide easy people. Banks are considered as manufacturer of credit. It means they are not only the dealer of money but in actual meaning they are creator of credit.”
A single bank can not create credit. It is the banking system as a whole which can make loans more then their excess cash reserves.
Assumption of credit creation process:-
The process of credit creation is based on certain assumptions which are as under:-
There are many banks say A, B and C etc in the banking system.
Each bank has to keep 20% of its deposits as required reserves. In other words 20% is the reserve rate fixed by law.
Business conditions remain normal in the country. Central bank does not adopt any credit policy.
The loan amount drawn by the customer of one bank is deposited in full in the second bank and that of the second bank into the third bank and so on.
Process of credit creation
The bank creates credit in four ways-
Discount Bills of Exchange.
Purchase of Assets.
By over drafting bank creates credit. Secondly, bank purchase the securities and paid them with ts own cheque. The holder of these cheques deposits them in the bank. They create deposits which is nothing other than creation of credit. It is recognized that the process of credit creation can’t proceed with out involvement of the whole banking system.
According to S mvelson,
“The banking system as whole can do what each small bank can not do. It can extend its loans and investment many times. The new reserves of cash created for it’s even though small bank is lending out only a fraction of its deposits
Limitation on the power of Bank to create credit:-
Following are the limitation of credit creation:-
Amount of Cash:-
The credit creation power of bank depends upon the primary deposits with the bank. The larger cash, the larger amount of credit that can be created by bank.
An Important factor that limits the power of bank to create credit is the availability of securities because the bank advance loans to its customers on the basis of secu ities or a share, or a bank, or a building or some oth r types of a
Banking Habits of the People:-
If people have more banking habits banks will create more credit and vice versa.
Legal Reserve Ratio :-
The ability to create credit also depends upon the cash reserves ratio imposed my central bank The higher this ratio the lower is the power to create credit.
Shortage of Borrowers:-
If there is shortage of borrowers due to business. Slump or due to any reason, the ability of banks to create credit will also be decreased.
If banks enjoy clearing house facility by the central bank then they can create more credit and vice versa.
Behaviour Of Other Banks:-
The power of credit creation is further limited by the behaviour of other banks. If some of the bank do not advance loans to the extent required of the banking system, the chain of credit expansion will be broken.
Policy Of The Central Bank:-
The central banks policy regarding the expansion and contraction of credit also restricts the credit creation by the commercial banks.
Cash In Circulation:-
If the loan issued by the bank may not be deposited in the bank. The cash may re ain in circulation can not be used by banks f r credit creation.
Bank can not continue to create credit limitlessly. Their power to create cr dit depends upon the economic climate in the country.
Summing Up:- We can say that creation of credit is an important function of commercial banks. However the power of credit creation by the bank is not unlimited.
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